Derivatives

Question 1

A derivative is a financial instrument that ___ its value from the performance of an underlying asset

Answer 1

• derives its value

Question 2

A derivative ____ the performance of the underlying

Answer 2

• A derivative “transforms” the performance of the underlying

Question 3

The party that agrees to deliver is ____ on the position

Answer 3

• short on the positon

Question 4

Derivatives are sometimes compared to ___

Answer 4

• compared to insurance

Question 5

Risk management def

Answer 5

• the process by which an organization or individual defines the level of risk it wishes to take, measures the level of risk it is taking, and adjusts the latter to equal the former

Question 6

Derivatives market
exchange-traded over the counter
futures & options Swaps, forwards, collar

Question 7

Exchange-traded derivatives are _____

Answer 7

• are standardized.
• ie bound by terms and condiions, and there is little ability to alter those terms
• no room for customization

Question 8

Advantages of standardization:

Answer 8

• Liquidity
• clearing and settlement process
• more transparent
• credit guarantee

Question 9

Over-the-counter derivatives market

Answer 9

• “dealer market”
• OTC contracts are negotiated directly between two parties without an exchange
• contracts are customized
• OTC markets have credit risk: each party bears the risk that the other party will default

Question 10

Key differences between exchange-traded and OTC:

Answer 10

Feature: Exchange-traded: OTC:
-Rules standardized customized
-Where are the exchanges dealer network
contracts traded
-Intermediary yes, the exchange no intermediary
-trading, clearing, centralized decentralized
and settlement
-liquidity yes almost the same
-transparent high no
-level of regulation high low
-flexibility/privacy no yes
-margin required yes may or may not be
EXAMPLES futures and options forwards and swaps

Question 11

Types of derivates:

Answer 11

• forward commitmments: forwards, futures, swaps

- contingent claims: options, credit derivatives, asset-backed securities (CMO,CLO, CDO)

Question 12

Forward commitments:

Answer 12

• bother parties have an obligation to complete the transaction
• forwards, futures, and swaps
• a contract that requires both parties to engage in a transaction at a later point in time on terms agreed upon today
• *forwards and futures have a $0 value at the initiation of the contract.

Question 13

Contingent Claims

Answer 13

• seller has an obligation, buyer has a right but no obligation to complete the transaction
• options, credit derivatives, asset backed securities (CMO, CLO, CDO)

**options have a non-$0 value at initiation, equal to the option premium

Question 14

Forward Contract

Answer 14

• an OTC derivative contract in which two parties agree to exchange a specific quantity of an underlying asset at a later date at a fixed price
• customized and private
• not traded OTC!

the long hopes the underlying will increase in value
no money is exchanged at the start of the contract: value of contract is $0 at initiation

Question 15

Futures

Answer 15

• a futures contract is a standardized derivative contract: traded on a futures exchange
• two parties agree to exchange a specific quantity of the underlying asset at an agreed-upon price at a later date
• futures have daily price limits
• gains or losses are settled on a daily basis by the exchange through its clearinghouse (mark to market)

Question 16

What is a swap?

Answer 16

• an over-the-counter contract between two parties to exchange a series of cash flows based on some pre-determined formula
• the simplest swap is a plain vanilla interest rate swap

Question 17

European Option

Answer 17

• the option can be exercised only on the expiration date

Question 18

What are the three types of contingent claims?

Answer 18

• options, credit derivatives, and asset-backed securites

Question 19

What are credit derivatives

Answer 19

• a derivative contract between to parties, a credit protection buyer and a credit protection seller

Question 20

Credit default swap

Answer 20

• a type of credit derivative
• a form of insurance
• buyer of protection to cover loss of par value of the bond, if a credit event occurs
• transfers risk to the protection seller

Question 21

Benefits of derivatives:

Answer 21

• risk allocation, transfer, and management
• information discovery: futures prices reveal more info than spot prices
• operational advantages: lower transaction costs than the underlying, greater liquidity than the underlying spot markets, easy to take a short position
• market efficiency

Question 22

Asset-Backed Securities

Answer 22

• a derivative contract in which a portfolio of debt instruments is assembled and claims are issued on the portfolio in the form of tranches, such that the prepayments or credit losses are allocated to the most junior tranches first and the most senior tranches last

Question 23

Hybrid derivatives

Answer 23

• a callable bond or a convertible bond

Question 24

A hedge portfolio should earn the ___

Answer 24

• risk free rate

Question 25

Arbitrage

Answer 25

• an opportunity to make a profit at no risk and with the investment of no capital
• arbitrage leads to the law of one price